Sector Investing

Different sectors lead each phase of a bull market. Sector Investing is covered in Chapter 8. When a sector becomes popular, investors begin hearing a lot about its prospects (availability heuristic), all stocks in the sector appreciate regardless of fundamentals (Representative Heuristic), everyone begins investing in the sector (herding), everyone becomes optimistic (overconfidence), making bad decisions (Winner's curse, as when TISCO purchased CORUS), and so on. A sector bubble occurs when many new companies enter a sector, and their stock prices rise without regard for fundamentals. When investing in sectors, investors should exercise extreme caution. It is critical to leave at the appropriate time. When the tide turns, a sector bubble can burst very quickly.

Lessons:

Investors get trapped in the Growth Trap when they invest in hot and fancy sectors in the markets.

1. Investors end up paying crazy valuations for stocks when they chase stocks in the current hot sectors. This affects their long-term returns. This could also lead to capital depreciation.

2. When a sector is hot, new companies taking advantage of the market conditions enter the market with initial public offerings to cash in on the investor fancy. This leads to investors paying fancy prices for mediocre companies. Beware of IPOs.

3. Investment bankers try to cash in on the fancy sector by selling sub-par paper to the investors.

4. Be careful of the information fed to you by the media. Be wary of your favourite stock market TV shows. Carefully scan various buy recommendations from intermediaries.

5. Rapid growth in a sector does not mean good investment returns for the investors. The inverse is true. Investor returns are dependent on the right acquisition price.

6. A sector changes slowly, but companies’ fortunes can change rapidly. Misguided portfolio allocations based on sector growth can lead to the acquisition of mispriced securities.

7. Sector bubbles are a warning to investors to reduce their allocation to the sector. For example, we saw the IT sector bubble in 1999–2000. A similar bubble is evident in the real estate sector. Such sectors are not for the long-term investor.

8. A deflated sector, like FMCG or healthcare, offers good investment opportunities for long-term returns. The companies in these sectors are also available at reasonable PE multiples.

9. Do not buy what others are also buying. Long-term returns are a function of buying what others are not buying. It is here that you get the price advantage.

Key Takeaways

Sector investing is also a type of stock investing. You do not have to buy what is popular. You don't have to buy what everyone else is buying because it's already too expensive. According to representative thinking, you don't need to invest in a hot sector because the stocks in that sector are all overpriced. Furthermore, when a sector is performing well, an investor is more likely to fall into the growth trap because the company chosen in the sector may be incorrect.

Alternatively, when a sector performs well, unscrupulous managements enter the sector with flawed business models, causing investors to pay exorbitant valuations based on the sector. Companies would frequently change their names to reflect the current hot sector in order to attract investor attention. Based on our previous discussions, it makes sense to look at a sector with sustainable economic characteristics performing poorly due to a lack of investor interest. The challenge would be to find the right company in the sector. 

Companies in out-of-favour industries can produce healthy investor returns. In and of itself, forging is a very dull industry. It lacks the charisma of technological innovation or the desire for growth. It was a neglected sector in the early 1980s, and few companies wanted to be in it. Only a few companies remained in the sector following the departure of companies due to uneconomic scales. Bharat Forge was one such company. Its management focused on what it did best and increased efficiency. When the sector did not pique the interest of investors, there was little competition. This provided it with the impetus to construct an impressive moat around it. It ran a mediocre business efficiently and profitably for its shareholders. From 1979 to the present, it has returned an average of more than 31 per cent compounded returns to its investors.

Dividends are reinvested when calculating returns. At the time, both the forging sector and the company had obscure names. Similarly, FMCG is currently a neglected sector. Despite the poor economic conditions, the underlying business is viable.

Companies with a strong brand and an extensive distribution network provide good investment opportunities. So it is with a neglected sector such as technology. Oracle purchased IFlex Solutions for ₹2,100 per share. At ₹980, this stock is available for half the price. Is it possible to go wrong? The industry as a whole, as well as this fantastic company, is underserved.